Safehold Inc. (SAFE) Earnings Call Transcript & Summary

All right. Well, why don't we go ahead and get started. Thank you for joining us today. My name is Jason Fooks, Head of Investor Relations and Marketing for Safehold. The ticker symbol is S-A-F-E. We trade on the New York Stock Exchange. I thought I would share a presentation with you guys. Okay. So who are we? Safehold is the founder of the modern ground lease industry. We went public in 2017. In fact, we're the first and only publicly traded company exclusively focused on ground leases. The modern ground lease is a new and rapidly growing customer-friendly capital solution for a $7 trillion institutional-quality commercial real estate market. The business thesis centers around the idea that the entire commercial real estate industry is operating sub-efficiently. A modern ground lease enables our customers to separate 2 distinct real estate assets with 2 very different risk and return characteristics. Every single property is comprised of 2 assets. The first is the land, which is a passive, ultra-long duration, low-risk, low-return asset. And that contrasts with the building, which is an actively managed operating asset that generates higher returns, but with higher risk. So separating these 2 very different assets enables them to be owned by those owners who value their precise risk and return characteristics most highly. We've seen this type of separation consistently over the past 30 years throughout the capital markets enabled by securitization and throughout the corporate credit markets as well. We've seen that companies don't want to tie up capital in noncore balance sheet assets such as their headquarters. We've seen how hotel companies don't need to own their hotels and cloud companies don't need to own their data centers. So the modern ground lease brings that capital efficiency in the real estate markets at large, enabling our customers to earn higher returns on their capital from doing what they do best, owning and operating a building without having to tie up their capital in the lower-returning land assets. And for our investors, the ground lease delivers long-term, high-grade, low-risk compounding rent streams. Our capital is safe, as our security is not just the land, but also the entire building serves as collateral protection for our position. And on the day we close a deal, on the day we close a ground lease, we're locking in above-market yields for 100 years, creating significant value for shareholders. Our ground leases are modest in size of 35% to 40% of the total property value and they're well covered at 3 to 4x net operating income. And we invest only in institutional-quality assets with top quality sponsors in the top 30 urban markets in the U.S. And in addition to those rent streams, we're also building a growing portfolio of real estate interest because of the expiry of a ground lease. Well, we own whatever is on top of our land. And so our shareholders own an asset, which we call UCA, which is a fast growing portfolio of real estate interests, an asset class that has never existed before. And we think many investors today overlook that value of this asset, and we think it could be the most valuable part of the business. So since 2017, we've been on a mission to convince the market of those 2 things. One, that this is a better way of owning real estate that delivers real value for a very large marketplace of potential customers. And two, there's a tremendous amount of value for investors to be found in a growing portfolio of modern ground leases. We've had some considerable success on both of these missions, but we're just getting started and there's tremendous runway ahead. So with that introduction, I'll touch briefly on some slides that set out our customer value proposition, our financial and operating performance and our growth prospects, and ultimately, why we think our company is a compelling investment story. And then, hopefully, we'll have some time for Q&A at the end. So strong financial performance over the past few years. As the business has continued to grow, our revenue has grown nicely. Our net income has grown nicely. Our stock has been a strong performer. We were, in fact, the best performing Nareit stock in 2019. And then, again, we repeated that feat as the best performing Nareit stock in 2020. And, let's see -- but on the customer side, we have been making a significant amount of progress with our customers. We have grown this portfolio from when we IPO-ed from only $330 million, 4 years later we've grown it by 10x to $3.4 billion. So really meaningful growth over the past few years. That also includes a period of time, even during COVID, when the real estate markets largely kind of seized up. There was very little transaction volume. Of course, we couldn't do much origination during that period of time either. But after Labor Day, we started to see it thawing in the market, we started to have more customer engagement. And over the past 2 quarters, we've originated about $0.5 billion of ground leases. And you can see the quality of the ground leases that we're focused on. These are in major urban centers: Seattle, New York City, on the water in Honolulu, Washington, D.C., just a few blocks away from White House, Philadelphia and Los Angeles, multifamily, office, hotel, very high-quality, institutional-quality real estate. That's very important for the type of assets that -- type of portfolio we're trying to build. And so what is the value that we're offering customers? I mean, what we are ultimately offering customers is a more efficient capital solution that's built on the same idea that's transformed the capital markets and the corporate credit markets over the past 30 years. The capital markets, 30 years ago, we learned that our first mortgage isn't just a first mortgage. It's a AAA tranche and a AA tranche, and you can take all those different layers of risk and return and sell them to different investors who can more appropriately and more accurately price discriminate that level of risk and return. And the sum of the parts is worth more than the whole. In fact, over a relatively short period of time, it's become a $1 trillion business and has become the dominant form of any asset-backed financing, this sort of securitization structure. And at the same time, in the corporate credit markets, we've seen the same modernization happen as corporations have kind of moved into an OpCo/PropCo structure, splitting their passive real estate assets away from their core operating business. As I mentioned before, data centers and cloud companies don't need to own their data centers, hotels don't need to own their hotel buildings. Casinos have done it, have split apart, and retailers and restaurants and hospitals. It's happening across almost every single corner of the corporate credit world. But it has not made its way to the real estate world at large. And we think that we can bring that same dynamic that has created $2 trillion businesses net lease in corporate credit and the asset-backed financing world in the capital markets. We can bring that idea to real estate by taking a real estate property and splitting it into also 2 different assets, an operating high-return piece of building and a low-return, low-risk, completely passive land. And by letting the different investors on those 2 different assets, we can create a significant amount of capital efficiency. But that's just the first efficiency that our ground leases offer our customers. The second is a cost efficiency because real estate is a high friction business. Every single time you trade a real estate property, you have to pay transfer fees and mortgage reporting tax, you've got to pay your property broker and your mortgage broker, title survey insurance. All of those are based on a percentage of the value of the property. But if you split the property and provide a permanent home for the land away, then every single time that building trades, you're saving 1/3 of those fees, not just once, but over the course of a 100-year ground lease. That property can trade 10, 15, 20x, and so that value is quite meaningful. And the kicker on the right side of the page, the third efficiency, not only can we help our customers generate higher returns, not only can we help them reduce their costs, but we can actually take a meaningful amount of the risk that they face off the table because in real estate, it's not credit that is the biggest risk that real estate owners face, it's liquidity, especially credit at the moment of a liquidity issue. And so if your largest tenant leaves, you can work to re-lease your space. But if your larger tenant leaves and your mortgage is coming due, that's what causes real estate companies to go bankrupt. And we can take -- you can see in this diagram, it's a $100 million building and someone takes a $70 million mortgage, well, 5 years from now, they have a $70 million bullet they're going to have to deal with. But we can take half of that maturity risk, about $35 million and push it out for a lifetime, for 100 years that no one has to worry about that part of the capital structure, and it significantly reduces the risk that our customers have to deal with. And so this is a -- and not only have we had a lot of success to date, we're very excited about the opportunity ahead. We do think this is a very significant market. We have a nationally scaled platform with growing market adoption, growing market awareness and a pipeline of innovative products to meet our customers' needs. Earlier this year, recently, we were awarded debt ratings from Moody's and Fitch with an investment-grade debt ratings, Baa1, BBB+. On the heels of that, we recast our revolving credit facility and upsized it to be $1 billion, giving us a lot more flexibility, a lot more dry powder to pursue ground leases. And we did our first -- we did our inaugural unsecured bond issuance, $400 million 10-year note with a 2.8% coupon. So we're very excited about the ways we can continue to drive efficiency, not just for our customers, but also on the right side of our balance sheet with our capital structure with these new ratings. And so switching gears, that's the customer side of the story, and we do think that we've had the ingredients to disrupt a very large market, build a very large business and -- but what does that mean for our investors? What does a growing pool of ground leases mean for investors and why we think it's extremely valuable? Well, the first place to start is how safe a ground lease is because this entire business is wrapped up in owning the senior most part of a real estate capital structure. Ground leases occupy the senior most -- we typically target the senior most 30% to 40% of a capital structure. This diagram kind of shows the midpoint of that. And when you look at a typical CMBS capital structure, that 35% to 40% attachment point lines up very nicely with the AAA tranche, maybe the AA tranche. And so you get a sense of just how safe our portfolio of ground leases are. In fact, we got to stress test it somewhat during COVID, and what we saw was that 100% of our ground rent was paid throughout the entire pandemic. So that gave us an opportunity to really test exactly how safe a ground lease is. Okay. That's great. Ground leases are very safe. Ground leases -- but what sort of returns should a ground lease generate? Well, as it happens, we don't have to guess. There's -- there are benchmarks out there of what very high-grade, ultra-long duration cash flows should yield. Our ground leases are structured to be fixed cash flow streams that escalate every single year by 2%, and they're generally 99-year contracts. There is a whole handful of very high-grade, unsecured 100-year bonds that trade in the market every day, the most liquid of which and the largest of which is MIT has about $2 billion of unsecured AAA bonds, 100-year bonds. And what we can see is that those bonds yield 3.3% today. So if you want to buy one of those bonds, the market says that you've got to -- from this -- put -- park my capital in this security for 100 years, I want to earn 3.3% on my money. Well, let's take a look at what our ground leases do. Our ground leases start off between 3% and 3.5%. Let's say, the midpoint is 3.25%. So they start off at actually about the same level as what our benchmark does. But our ground leases have contractual escalators every year. Every year, the rent goes up by 2%. That compounding return is quite powerful, especially when you talk about over a long period of time. And you can see how our ground -- how our cash flows grow over time. In fact, if you discount our cash flows, if you take the NPV of our cash flows using the market benchmark, every dollar we invest, every ground lease we originate has an NPV of $1.80. That's a really powerful machine every -- and so growth is extremely accretive. And so we think as we continue to scale, the market will continue to recognize the power of this machine. In fact, I think a lot of the performance that we've seen in the stock so far is really the market getting their heads around just how accretive this business is and reflecting the kind of cash flow value of our existing portfolio. But this is only half the story because as I mentioned before, ground leases generate a very, very safe, very, very stable cash flow stream. But this math is based on the fact that just like a bond at the end of the lease, you get your original investment back, you get your principal back, your par, but that's not how a ground lease works. With a ground lease, we own everything on top of our land. We take our land back, we take the building back. Everything at the end of the life of the lease that's sitting on top of our land, we own. And so we've been tracking that value for the market, and we call this unrealized capital appreciation. And so sitting on top of our land today is $5.6 billion of bricks, mortar, steel, glass, concrete, all of which we are ultimately the long-term owner of it. And so we think that this asset has the ability to grow significantly, and we are just starting now to help the market think about how -- a valuation framework for it. Because it wasn't always $5.6 billion. When we started our business 4 years ago, the bricks and mortar sitting on top of the land was only about $440 million. But as we scale, as we continue to originate more ground leases and bring more cash flow into the portfolio, behind the scenes, we've been growing this large pool of high-quality future ownership interest in real estate. And we have CBRE go out and appraise these assets every year. We publish the number every single quarter. And so you can see the growth rate over a relatively short period of time, how that pool has grown from $400 million to $5.6 billion over 4 years. So how should investors think about that? Well, our argument is that you should think about it the same way you think about any asset, which is not net present value, NPV. Most people looked at that and said, okay, well, $5.6 billion, 99 years from now, if I discount that at a kind of real estate equity return, let's say 6%, well, 99 years from now, that's worth nothing or very little, right? And that's true. And what we said is, well, hold on a second, this is professionally managed real estate. It's being maintained, it's being invested in, it's being -- so generally, real estate should grow with inflation. And they said, okay, that's fair. So we'll take your $5.6 billion, we'll grow it by 2% a year and discount it back by 6%, and it's still not worth much. And we said, and you're forgetting one last component because the growth rate of the portfolio is not just the internal same-store growth rate. This is a going concern business. This is a machine that every day, every quarter is out there originating more ground leases. And every time we originate a new ground lease, we get to add another real estate interest into this pool. And so just like you would for any other company, there is an internal growth rate and an external growth rate that needs to be factored in. And when you factor those things in, the numbers start getting quite different. We've -- obviously, these are assumptions, and you can play with these assumptions. But the formula is -- I think, is generally accepted and it's just a matter of what inputs you want to put into this. And so to keep things simple, if we assume long-term real estate grows with inflation, there's lots of studies that suggest that, that's an accurate stat. I think most of our customers -- most of our real estate developers that can operate the buildings on top of our land probably believe that they can do better than inflation, but let's just go with inflation. Green Street, which is a reputable kind of real estate advisory and research analysis firm, publishes monthly a discount rate on what long-term discount rates on real estate institutional quality commercial real estate are. Right now, for a while, it's been around 6%. And then -- so the only question is what's the growth rate? Well, let's keep the math simple, and let's use 4% because 4% allows the overall growth rate in the numerator to be 6% and the discount rate in the denominator is 6%. And so if you grow anything 6% and discount it 6%, well, the math is very simple, you're just left with the starting value. And so, today's value of $5.6 billion, growing at 6% and discounted at 6%, is $5.6 billion. And so you can see the sensitivity table at the bottom of the slide here. If we assume 4% growth and discount rate of 6%, that is $5.6 billion of value. We have 55 million shares outstanding. Yes, management has some -- an incentive plan, which you can burn some of that out, but you're still sitting at close to $100 a share of value that the market has not really talked about, the market has not really taken the time to understand, and we're just starting to lay that out. Of course, 4%, you may ask, is that a reasonable number? Well, obviously, you've seen over the past 4 years, it's been closer to 100%. But is 4%, a reasonable number? Well, let's take a look at what we have to do from an originations perspective to continue to stay on this external growth of 4% curve. It means that this year, over the coming year, we have to originate $121 million of ground leases. It means 5 years from now, we'll have to originate $150 million of ground leases. It means that 20 years from now, we'll have to originate $366 million of ground leases. Over the past 2 years, we've averaged over $1.1 billion of ground leases, and that includes a period of time in which COVID significantly disrupted our ability to originate deals. It also includes a period of time when we didn't have investment-grade ratings and we didn't have access to the unsecured bond market. And it included a period of time where we were still ramping up the business. And so, we feel that -- 4% feels like a very doable number, certainly for quite a while. And so, we're very excited about what this -- we're very excited about the prospects ahead. We're very excited about the opportunity. And we're looking forward to have a discussion with our investors as we get this new valuation framework out into the market. And so with that overview, I am happy to take some questions. And I believe that you can ask questions in the Q&A box or you can put them in the chat. I'm happy to dive into any of those slides or topics a little bit further.

Well, I will ask some questions on -- that I've heard that might be interesting for you guys to hear about. One question is interest rates, right? Interest rates, there's a lot of concern about inflation. There's a lot of concern -- interest rates have recently moved. They've actually come right back down, but there was some concern that interest rates can move. And what doesn't move in interest rates mean for a portfolio that you've described as a very long duration bond? Well, that's a great question. I'm glad you asked it. I think that it's absolutely true that for our static existing pool of assets, a move in interest rates, that discount rate, that MIT bond rate goes from 3.3% to 3.5%, it has a negative impact on the present value of our cash flows. No question about it. That is offset by 3 things that, I guess, that are important to note. The first is we have long-term debt. Our -- we borrow 30-year secured debt on our existing pool. We're starting to tap the unsecured markets. And we look forward to borrowing increasingly longer rates in the unsecured world as well. And so what that allows us to do is while the existing pool of cash flows are worth less, the long-term bonds we have are worth more. And so what we have is really we've locked in a spread over a long period of time. And so that's one offsetting factor. The second offsetting factor is this idea of the unrealized capital appreciation. This -- if inflation is -- I'll share the slide again. If inflation is 2%, right, that's what we assumed here in that buildings over long periods of time grow with inflation. But if you believe inflation is 3%, this -- or even 4%, $5.6 billion starts looking really, really valuable. The growth of this pool of assets is growing faster, then that could significantly increase the value of a pool of assets. And so I think that's another important thing to consider. And then, finally, the third thing, growth. Growth will be a major offsetting factor, all of these things, because even though the existing pool of assets has a low -- kind of -- will decrease in value, it's still very accretive. Growth is still very accretive. And so as we continue to originate more deals in whatever interest rate regime we're operating, it will be very accretive. I've got a question, how is the debt structured and what protection covenants and adjusting factors do you incorporate into it? So I think that the question is probably around how are our ground leases structured, but I'll answer both how our debt is structured, how our ground leases are structured. Our ground leases are structured to be really, really simple. We think that they should be very simple because we're sitting at such a senior position in the capital structure. And so generally, we have a predetermined contractual rent stream, which is -- will go in, as I said before, between 3% to 3.5% cash yield. That cash yield rose 2% a year, every year, for 100 years. So everyone along the way, every future lender, every future buyer knows exactly what the ground rent will be in any year in the future. We put as little covenants as possible to give our customers maximum flexibility. They are -- we are heavily aligned with them. We want them to make the properties better. They have every incentive to make the properties better and protect the properties. And so we don't think we need to put restrictive covenants on them. There are covenants that require them to maintain the property and things like that. But again, this business is about creating deep alignment with our customers. We think that our customers are incentivized to take care of these properties for their own selfish interest. We do have a couple of sticks that we have built into these leases that hopefully we never have to use. And then in terms of our own debt, up until recently, we've been borrowing on a secured basis. When we borrow on a secured basis, 30 years, which is actually pretty interesting because before Safehold got into this business, the longest you could borrow in real estate on an interest-only basis is 10 years. There was no longer than 10-year ground debt product in real estate. We needed to kind of create that market. And so, we have gone to life insurance companies who, by the way, love ground leases. They just don't have an ability to originate them, right? This business is -- the hardest part of the business is originating ground leases. That takes a lot of entrepreneurial energy to do it. So they love this product. We've essentially created a structure by which they could invest in this product through the debt. We've gone 30 years with them. Then we did 40-year debt. We've done 50-year debt. And then the other thing that's important about the debt that we have originated, at least on the secured side, is because our ground leases start up low and grow over time, we actually pass that same structure over to our lenders, too, which is our debt starts off low and then we pass some of that 2% growth to our lenders. And so it allows us to not only be very accretive from an economic basis, but allow us to be cash flow positive from year -- from day 1 as well. Another question we got is, how do you source leases? That's a great question, and it certainly is the most important execution part of this business. We have a national platform, investment platform with about 25 or so originators organized in 6 regional markets with a regional lead across each of those markets. And so responsibility is to be involved in every single -- understand what are all the transactions that are going on, who are the players, what are the -- what properties are moving, what are the needs. We work really closely with the top 5 brokerage houses to make sure they understand the product, and I think they're now very well versed. And so we do get a good amount of deal flow from the brokerage community that kind of brings us in, in situations where they think they can be valuable. And so, it is -- but it is definitely a -- making calls part of the cycle. We definitely got our boots to the ground, talking to customers about how this product is innovative, how this product changes the entire competitive landscape for them. Once we convinced a customer of how it works and once they try it, the likelihood that they want to do more deals with us, the repeat business has actually been really encouraging. In fact, actually oftentimes, the people they're bidding against and they win against will call us, too. How do they -- what do you guys do for them? How do you structure that? How can they afford to pay that much? And what's this ground lease? What did they do for them? And so that actually is another source of business for us. From a capital -- another question that came in, from a capital-raising standpoint, are you able to resell your debt in the secondary market for additional capital? Well, I'm not sure. Our debt is very long term, and it's -- we're not trying to sell our debt. The way we raise capital is we raise equity and we raise debt. We typically lever ourselves 2:1. That's kind of our target. We're actually seeing a more conservatively levered than that today. But we have been frequent issuers of equity. We come to the market to raise capital, both as equity and debt as we continue to scale the business. So the capital structure is actually fairly simple. We have a bunch of common stock, and then we have some secured debt, which is what we've been doing up until this year. And then recently, we've started doing unsecured debt. What milestones should we look forward to in the future? That's great. I think there's 2 catalysts in my mind, maybe 3 catalysts in my mind for the business. The first is as we continue to scale, and we put a public target out there that we want to get to $6 billion of ground leases by the end of 2023, which effectively was doubling the portfolio over the next 3 years when we had made that guidance initially that target. So I think as more awareness around this -- as we see more awareness around this product, as more adoption around this product, as more competition comes in, and we do understand that there are new platforms that are being set up and are now also offering competing products, at the end of the day, this is about revolutionizing the way a very large market thinks about owning their real estate. This was -- when we were involved in -- we were involved in kind of introducing mezzanine debt to real estate, tranching the real estate capital structure in the early '90s when the securitization market was building steam, at first, there was a very few number of people and then more and more people got involved. And again, that became $1 trillion industry. And we were involved in helping corporations be much more efficient in the net lease business for a long time. And again, that business has grown as more people have understood its power, and that's also become a $1 trillion business. This also needs to kind of start building a mass and the gravity and attracting more people to it. So one day, we'll go from kind of making calls to taking calls, and I think that will be an important catalytic moment. As the market understands the unrealized capital appreciation, we just started talking to people about that, but there's an enormous store of value built into that portfolio. And we think as we educate the market and get this public dialogue going around this valuation framework, we think that could be a catalytic moment as well. A question about competition. So, yes. We were the first and only publicly traded company. We founded this industry -- this modern ground lease industry, taking -- building on a lot of the ideas and a lot of the businesses we've built over the past 30 years. But success inevitably will lead to competition. We've had a good amount of success. And so, that's right, we understand that there are at least $2 billion platforms that have been established that are out there trying to also originate ground leases and spread the awareness and hopefully build adoption and hopefully accelerate the huge enough innovation and move ground leases from something that kind of early adopters and entrepreneurs are using to make themselves much more competitive and using as a technological advance -- technological advantage in their businesses and moving ground leases from there to the majority, to the mainstream. And that is a moment in time when the entire growth trajectory of this business changes. And so the faster we get there -- the faster, the better.

We do have one -- time for one more question, if there is?

So one other question I get is Safehold -- the relationship between Safehold and iStar. So Safehold is -- Safehold's largest shareholder is iStar, which is also a publicly traded company. Safehold's manager is iStar. And so what's the deal with that relationship? And the answer is iStar had founded this idea -- iStar had come up with this idea, wanted to prosecute it inside the 4 walls of iStar. But candidly, it was just -- iStar's just too complicated and this ground lease business just would have gotten lost. And so we decided at iStar to structure like a joint venture. So iStar own 50% and our partner, in this case, will be the public. And so that's kind of how we think about -- iStar's been only a buyer of Safehold. It's not been a seller and highly aligned to make sure that Safehold is successful. And possibly one other catalyst here is that at iStar, we've talked about a strategy to go all-in on the ground lease business to ultimately transition iStar into being primarily a ground lease business and ultimately taking a look at the architecture -- possibly be in a position to take a look at the architecture between SAFE and STAR by the end of next year. And so iStar is working steadily to simplify its business so that they can complete this transition and then evaluate the external kind of relationship between SAFE and STAR by the end of next year. I think there's -- what are the target profile of your leases? I'll answer that really quickly. So generally, our target profile is we want to sit somewhere between 30% to 40% of the capital structure. So very, very safe, very, very passive, very, very sleepy part of the capital structure. We want to be covered our ground lease coverage to be around 4x coverage, which again is very, very safe, very, very comfortable coverage ratio. Generally, our ground leases start off between 3% to 3.25% going in cash yield, and it bumps 2% a year for 99 years. That's -- those are the typical terms of our ground leases. They all look fairly similar. We do put into our ground leases, in addition, a CPI look-back every 10 years. So if inflation runs faster than 2% over a 10-year period, then in year 10, you can kind of look back and catch up -- those are other things that we put into the ground lease structure. Generally, very low in terms of -- very flexible, little maintenance. There's a maintenance covenant that they have to maintain the property in the condition they received it. But other than that, there's -- we're trying to give our customers maximum flexibility. The ground lease should be a very passive part of the capital structure akin to real estate taxes, if you will.

Thank you, Jason.

Well, I appreciate everyone's interest. Great questions. Enjoyed the discussion. If you do have any further questions, feel free to reach out. Looking forward to speaking with you guys.